The second quarter of 2015 was more volatile and ended flat to down for major asset classes around the world.
Shortly after the broad U.S. market (S&P 500) achieved a new all-time high, the market began to reverse direction on a negative U.S. GDP reading that could not be explained. In fact, a CNBC study (http://www.cnbc.com/2015/04/21/the-mysterious-case-of-weak-1q-gdp-for-30-years.html) identified problems with the first quarter GDP data going back 30 years, even after adjusting for seasonality. Many argued the negative GDP number was the result of an abnormally harsh winter, but the credibility of the GDP data is left in question and that is never good for the stock market. Outside of the U.S., the crisis in Greece flared up again when negotiations with the finance ministers of Europe broke down near the end of the quarter. As of the time of this writing, the negotiations over Greece look more like a school lunch room fight rather than serious people looking for real solutions. The economic slowdown in China has gathered tremendous steam, forcing the People's Bank of China and the centralized government to take aggressive steps to intervene. The World Stock Market was essentially unchanged over the second quarter of 2015.
If we look at broad market indices for the second quarter of 2015, emerging markets outperformed both the U.S. and international developed markets (in U.S. dollars), while REITs underperformed other major asset classes.
Fixed Income markets during the second quarter reversed much of the unanticipated strength of the first quarter and the yield curve is now steeper, closing in on the same level of long term rates as June 30th, 2014. The U.S. aggregate bond index is now negative for 2015 and the more volatile long term government bond index is down 4.52%.
A DEEPER LOOK
One famous investment phrase is “Don’t bet against the Fed” (and all of the central banks world wide, for that matter) and the primary reason is it has many powerful tools to implement monetary policy that affect the economy. Since March of 2009, the Fed has used significant quantitative easing (QE) and a zero interest rate policy (ZIRP) with a twofold goal of hitting 2% target inflation and full employment. The Fed is achieving the goal of employment, the Bureau of Labor Statistics (BLS) chart shows total U6 unemployment down to 10.5%, from 12.1% one year ago and U3 headline unemployment down to 5.3%, from 6.3%, one year ago. See http://www.bls.gov/news.release/empsit.t15.htm
The secondary goal of 2% inflation has been extremely hard to achieve. All that can be said of the extreme use of inflationary monetary tools is that the U.S., Japan and Europe, as developed markets, have avoided a deflationary spiral. Currently, the S&P 500 has a very strong lower left to upper right trend line since March of 2009 (other U.S. indices are similar) and this trend line is still very much intact. (10 year chart of S&P 500 source: Yahoo Finance)
The side effect of zero short term interest rates, although many will argue it is a primary objective, is the wealth effect or the inflation of equity assets so investors feel wealthier and more willing to spend. The problem with inflating equity prices is bubbles are formed and valuation does not revert back to mean, it snaps back well below once a catalyst hits and a recession is in place. The best chart for determining the start of a recession is the 4 week moving average of initial unemployment claims. A level of claims below 300,000 is associated with a monthly jobs gain of 200,000. The chart shows an upward turn in unemployment claims prior to each past recession. It will be interesting to see how the breakdown in the energy sector affects this number going forward.
Notice that we are now at a level of jobless claims below the lowest levels of 2006.
The recent data, June 11th release, on U.S. retail sales was better than expected, up 1.2% from the previous month and 2.7% above May of 2014, https://www.census.gov/retail/marts/www/marts_current.pdf and may be a result of consumers finally feeling the effect of lower gas prices. The trend line of retail sales over the past 5 years also looks positive and is important since over two thirds of U.S. GDP is consumer spending (71% in 2013). (source: Used with permission from YCharts)
Commodity prices have declined substantially in the last year and this argues for a weakening global economy, not a strengthening one. The three broad commodity indices are down 25% and more over the past year. However it may be the slowing down of China that is really affecting commodity prices since China is no longer buying the massive amounts of material as in the past to build cities. The ten year commodity chart shows a reversion to price levels last seen in 2010 (source: www.indexmundi.com).
The real question today if we want to compare stock markets to 2006 (and avoid a significant correction) are the state of asset class valuations. All evidence points at extended asset price valuations, which one would expect given the amount of global monetary stimulus that has been provided. We can’t use the P/E ratio as a measure of valuation since empirical evidence proves it has no predictive power, unless you use 10 year earnings as the denominator. This ratio is known at CAPE or PE10 and it is at extreme levels, approaching the peak in 2007. Another way of looking at this is how often the PE10 is at this level vs. all other levels over history and once again it does not look favorable but rather close to other time periods associated with extreme bubbles, see http://www.advisorperspectives.com/dshort/updates/PE-Ratios-and-Market-Valuation.php
The problem with the PE10 or CAPE ratio is that it has very little predictive power in the short term. We could very easily pass the 2007 peak and stay there for a lengthy period of time. We could also take a look at the price to sales ratio (or the S&P 500 market cap to revenue). This ratio is at a decade high, http://www.multpl.com/s-p-500-price-to-sales
The strong trend line of the U.S. markets is starting to show signs of a late stage winner with higher highs reached on higher volume and less breadth (fewer companies reaching highs). The China slowdown (not growing as fast as previous years) is real and very difficult to gauge since the data is not reliable and communication not as transparent as other developed markets. As we mentioned earlier in the newsletter, when data is questionable, investors place a higher risk premium on securities. The latest release of leading economic indicators in China stated an increase of 1.1% in May, following a 1.4% increase in April and a 0.2% increase in March. The PBOC has cut interest rates and reduced bank reserve requirements and neither have stemmed the stock market slide, a great concern. Also of concern for the Chinese stock market is the additional risk premium that will be required due to liquidity risk (when the government forces you to hold your stock for at least 6 months, that is problematic for healthy markets). Over the previous weekend of this writing, major brokerages in China announced the collective purchase of $20 billion worth of equities to attempt to stop the sharp correction (at the direction of the government). The Shanghai markets opened up 7%, lost the entire gain and then rallied at the close to finish the day up 2.4%. The following two days witnessed gains above 4% each day. China stocks are off the charts volatile.
Is Greece going to be a catalyst for a correction with the “no” referendum selected by 61% of the Greek citizens on July 5th? It is possible. The banks and stock market are still closed in Greece, the economy is declining rapidly. Greek citizens awoke Monday, June 29th, to capital controls on their banking system. The negotiations between the financial ministers of the Euro group, ECB, IMF and Greece, after four months of meetings, have reached an impasse; and Greece called a referendum for July 5th to vote on the latest bailout package, which includes more austerity measures for Greeks (higher taxes, reduced pensions, etc.). Greece owes a debt payment from a previous bailout to the International Monetary Fund (IMF), which was due on June 30th; and as everyone expected, Greece defaulted on the payment. The rating agencies did not call it an official default since it did not involve publicly held bonds. The Greek banking system needed emergency funds to meet all of the withdrawal requests from their depositors and the ECB denied the extension of emergency liquidity (short term loans), which means Greece was forced to implement capital controls to protect their banks. Depositors are limited on amount of money they can withdraw from ATMs (60 Euros per day) and pension accounts are limited to the amount they can withdraw. This is going to be a challenge for the Greek people as their economy will be negatively affected and is already in bad shape (GDP has declined 25% over the last five years). The country is only 11 million people and the GDP of Greece is only 2% of the Euro zone, therefore the Greek crisis should not have much of an impact on the Euro zone economy. The banking system in Europe will very likely be protected by the European Central Bank (ECB), which has significant flexibility (certainly the power to save the Greek banking system).
So far, the only significant decline in asset values are Greek bank stocks and Greek bonds. This was obviously not expected, nor priced in, but very local to Greece. While the spread between the German 10 year bund and the Greece 10 year government bond has widened significantly from a low of 5% last summer to over 15%, it is still below the 2011 levels (well above 20%). The only investors in Greek bonds are those that know the risk involved is high. The bond spreads between Germany, Italy and Portugal are not widening significantly. Investors right now are not worried that the Greek crisis is going to spread to Portugal or Italy, both much larger economies. The Euro as a currency, has held up very well near $1.11 in the last two weeks. The volatility index (VIX) is within its trading range and not anywhere near highs of the last year, so volatility is contained. Germany does not want to see the Euro group fail and there is no established process for the nation of Greece to exit the Euro as a currency bloc. The U.S. also wants to see a solution since Greece has met with Russia and both Russia and China would like to provide economic assistance to Greece, in return for a stronger political foothold in Europe.
We continually remark in our Investment Committee meetings that this time period involves an enormous and unusual amount of government and central bank manipulation in the markets. At a time when a political decision can have an immediate impact on asset class values, it is as important as ever to have a clear empirically-based portfolio methodology. Just like a baseball player needs to know what he is going to do with baseball if the ball is hit to him or someone else based on the conditions on the field of play, a portfolio manager needs empirically backed methodology in place to manage volatility and base purchase and sale decisions on.
Lake Tahoe Wealth Management was prepared for this potential crisis as detailed in our last two quarterly commentaries and we are keeping client portfolios at their target levels (with a slight overweight to cash from our activities over the past six months) while allowing our very active monitoring and rebalancing process to steer our trades. Effectively, our rebalancing process assists us in buying while prices are low and selling when they are high. In the past 18 months, we have been selling asset classes that have reached 20% above target and rebalanced back to target. If we expected a black swan event, where all asset classes go down together in response to a significant global crisis, we would actively move more assets into cash. However, we do not possess any innate ability to foresee the future, and neither does anyone else; which is why we adhere to a rigorous, disciplined, academically vetted, empirically based portfolio management methodology that we can tie directly to client goals through the financial planning process (no robot is going to do that any time soon!). While we recognize the heightened valuation of both stocks and bonds right now, the developed economies in the world are not yet flashing major warning signs, especially in the U.S., and it is hard to fight monetary policy by the central banks. We are watching the ECB and Federal Reserve closely as the lenders of last resort and providers of liquidity to the global financial system. We also recognize our primary role is not to make predictions on asset class movements, which is impossible, but to help our clients achieve long term success by taking on multiple roles in the fiduciary relationship - such as portfolio manager, financial planner, educator, and coach. So if looking into a misty crystal ball is not how an advisor adds value, what is it that an advisor does for clients?
THE SEVEN ROLES OF AN ADVISOR
What is a financial advisor for? One view is that advisors have unique insights into market direction that give their clients an advantage. But of the many roles a professional advisor should play, soothsayer is not one of them.
The truth is that no one knows what will happen next in investment markets. And if anyone really did have a working crystal ball, it is unlikely they would be plying their trade as an advisor, broker, analyst, or financial journalist.
Some folks may still think an advisor’s role is to deliver market-beating returns year after year. Generally, those are the same people who believe good advice equates to making accurate forecasts.
But in reality, the value a professional advisor brings is not dependent on the state of markets. Indeed, their value can be even more evident when volatility and emotions are running high.
The best of this new breed play multiple and nuanced roles with their clients. None of these roles involve making forecasts about markets or economies. Indeed, there are at least seven hats an advisor can wear to help clients without ever once having to look into a crystal ball:
1. The Expert: Investors need advisors who can provide client-centered expertise in assessing the state of their finances and developing risk-aware strategies to help them meet their goals.
2. The Independent Voice: The global financial turmoil of recent years demonstrated the value of an independent and objective voice in a world full of product pushers and salespeople.
3. The Listener: A good advisor will listen to clients’ fears, tease out the issues driving those feelings, and provide practical, long-term answers.
4. The Teacher: Getting beyond the fear-and-flight phase often is just a matter of teaching investors about risk and return, diversification, the role of asset allocation, and the virtue of discipline.
5. The Architect: Once these lessons are understood, the advisor becomes an architect, building a long-term wealth management strategy that matches each person’s risk appetites and lifetime goals.
6. The Coach: Even when the strategy is in place, doubts and fears inevitably arise. At this point, the advisor becomes a coach, reinforcing first principles and keeping the client on track.
7. The Guardian: Beyond these experiences is a long-term role for the advisor as a kind of lighthouse keeper, scanning the horizon for issues that may affect the client and keeping them informed.
These are just seven valuable roles an advisor can play in understanding and responding to clients’ whole-of-life needs, which are a world away from the old notions of selling product off the shelf or making forecasts.
Knowing the advisor is independent—and not plugging product—can lead the client to trust the advisor as a listener or sounding board. From this point, the listener can become the teacher, architect, coach, and, ultimately, the guardian. Just as people’s needs and circumstances change over time, the nature of the advice service evolves.
However you characterize these various roles, good financial advice ultimately is defined by the patient building of a long-term relationship founded on the values of trust and independence and knowledge of each individual.
Now, how can you put a price on that?
Adapted from“The Seven Roles of an Advisor” by Jim Parker, Outside the Flags column, May 2015.Dimensional Fund Advisors LP ("Dimensional") is an investment advisor registered with the Securities and Exchange Commission. Diversification does not eliminate the risk of market loss. There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results. All expressions of opinion are subject to change without notice in reaction to shifting market conditions.This content is provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.
1. Standardized Performance Data and Disclosures
Russell data © Russell Investment Group 1995-2014, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2014, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2013 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2014 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
Lake Tahoe Wealth Management, LLC is an investment advisor registered in the States of Nevada, New York, North Carolina, South Carolina, and Texas.
The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.
Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.
The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.
Fixed Income Portfolios:
The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.
Risk of Banking Concentration:
Focus on the banking industry would link the performance of the short term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.
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